MESSAGE to shareholders

Dear Fellow Shareholders:

2014 was a year of several important successes, and one disappointing setback. On the one hand, we entered our second decade as a company, posted strong financial results, settled the longstanding Cardinal contracting issue, saw the successful commissioning of one wind project and made significant progress on two others, ensured our facilities operated efficiently and with a near-perfect safety record, and supported our employees and the communities we serve.

On the other hand, we received a seriously disappointing regulatory decision at Bristol Water, despite exerting considerable effort in developing a business plan that combined service improvements with price reductions, was overwhelmingly supported by Bristol Water’s customers and was vetted by a number of third-party experts. As we explain later, this regulatory result will not be accepted without a challenge.

From the financial standpoint, 2014 was a very good year for Capstone. Adjusted EBITDA exceeded our forecast, coming in at $160.4 million, the result of a full year of contributions from wind assets we acquired in the third quarter of 2013, higher regulated tariffs and favourable foreign exchange effects from Bristol Water, and lower expenses associated with integrating the acquired wind assets. We also affirmed Capstone’s support for the annual $0.30 per share dividend to common shareholders.

Capstone’s foundation is a diversified portfolio of high-quality businesses, which gives us a solid footing as we plan to move past the current review process at Bristol Water in the summer of 2015 – and build on our considerable strengths, as we outline in this annual report.

ACHIEVEMENTS IN A MILESTONE YEAR

We Secured Cardinal’s Future with a New 20-year Contract
When we published our last annual report, the status of the Cardinal gas plant was still unclear once the power purchase agreement in place at the time expired on December 31, 2014. Following a complex multiyear negotiation process that began in 2009, we ultimately secured Cardinal’s future by signing a new 20-year contract in March 2014. Since January 1 of this year, Cardinal has operated as a dispatchable facility rather than a base load generator, earning fixed monthly payments that escalate annually according to a pre-defined formula, while supplying electricity to the Ontario grid when needed.

We Realized the Growth Potential of Our Wind Acquisitions
Capstone’s power segment is driving organic growth as we steadily complete the pipeline of wind power projects we acquired in 2013. We commissioned the Skyway 8 facility in 2014, and in January 2015 the Saint-Philémon wind farm achieved commercial operations. We expect the Goulais project to be commissioned in the second quarter of 2015.

We Invested in the Long-term Performance of Our Operating Portfolio
Responsibly managing Capstone’s facilities through systematic and predictive maintenance, scheduled capital projects and the introduction of new, efficiency-enhancing technologies optimizes the returns we generate from those assets. At Erie Shores, we complemented the WindBOOST system already in place by installing Turbine Pitch Optimization technology. The approved C$546 million asset management plan at Bristol Water, directed toward improving and expanding the system’s water mains, pumps and reservoirs, will be fully executed by the conclusion of the current five-year period, which ends on March 31, 2015. Cardinal is in the midst of a $30 million refurbishment and life extension as part of its new function as a dispatchable facility, a project that will wrap up in the spring of 2015 in a one-month outage. The Whitecourt biomass facility reached a new 15-year supply agreement with its fuel provider, helping to ensure the ongoing viability of this important asset in Alberta.

PRIORITIES FOR 2015

Bristol Water Regulatory Review
A pressing issue for the first half of 2015 is to secure a favourable regulatory outcome at Bristol Water. The long-term prospects for this utility are exceptional; however, the immediate priority is to challenge the five-year business plan recently determined by Ofwat, the economic regulator for water utilities in the UK. Bristol Water’s Board of Directors formally rejected Ofwat’s plan on February 5, 2015 and the matter now heads to the Competition and Markets Authority (CMA) for review. The management teams at Capstone and Bristol Water, along with leading consultants and industry experts, are making a concerted effort to ensure a better outcome is achieved. We discuss Bristol Water and the review process in greater detail on "Platforms and Performance Drivers" in "Our Strategy is Essential" section of this report; until this regulatory question is settled, the interim uncertainty is likely to continue to weigh on Capstone’s share price.

Growth Through Acquisitions
We recognize that shareholders expect Capstone to use its market position and diversified asset base to grow the company. I share that view, and would like to have made more progress in expanding into new pillars or acquiring more power and utilities assets in 2014. Although we did not consummate a transaction, we analyzed a number of potential deals in power, utilities, public-private partnerships and transportation throughout the year. This has led to some promising dialogues and new relationships, which we expect to bear fruit in 2015 and the years ahead.

We look for acquisitions that create enduring value for Capstone’s stakeholders. This simple principle requires discipline to ensure that potential deals are accretive over the long term, carry total returns within an acceptable range, reflect an appropriate amount of risk and are a good strategic fit with our company. These are the qualities that we adhere to, regardless of market cycles, when determining whether it serves our interests, and those of our stakeholders, to acquire assets.

Organic Growth Initiatives
Capstone’s power development team has proven its ability to execute projects on time and on budget. In August 2014 we commissioned the 10-megawatt Skyway 8 facility in Ontario, and on January 16, 2015 our 24-megawatt Saint-Philémon wind farm in Quebec achieved commercial operations. By the end of the second quarter of 2015, the 25-megawatt Goulais project in Northwestern Ontario should be commissioned. We have six other projects in the development pipeline, two of which have recently earned their Renewable Energy Approval, with construction on the first facility slated to begin in the third quarter of 2015.

In November 2014, Capstone was designated as a Qualified Applicant under the Ontario Power Authority’s Large Renewable Procurement, a competitive process for sourcing major clean energy projects in the province. We are evaluating potential projects in anticipation of an RFP expected in mid-2015.

Bristol Water is one of Capstone’s most significant sources of organic growth, with a 26% expansion in real regulated rate base during the 2010 to 2015 regulatory period. The regulated capital value growth profile for the upcoming five-year period remains strong, though the growth in long-term value would come to the detriment of current revenue, pending CMA review.

Renewed Focus on Sustainability
Capstone’s renewable energy portfolio naturally fits the definition of an environmentally sustainable business. We recognize, however, that sustainability also applies to how a business is run from a governance and social perspective. We have produced an expanded sustainability report this year as a companion piece to Capstone’s annual report, which is available on our corporate website. A summary of our sustainable business practices is also provided in the Strategic Overview section of the annual report. These initiatives reflect our abiding commitment to operating our business based on the ethics of honesty, integrity, transparency and respect.

OUTLOOK FOR THE COMING YEAR

Capstone’s business will evolve over the next two years, as Cardinal operates as a dispatchable facility, more wind power facilities achieve commercial operations, Bristol Water’s AMP6 business plan is ultimately resolved, and potential acquisitions are completed. In 2015, we anticipate Adjusted EBITDA of between $115 million and $125 million, which reflects the lower financial contribution from Cardinal and the impact of the business plan Ofwat determined for Bristol Water, which will be in effect from the second through the fourth quarters of 2015. If a beneficial outcome is reached following the CMA review, adjustments will take effect the following year. What will not change in 2015 is Capstone’s support of the $0.30 per share dividend for common shareholders.

The first ten years at Capstone saw the company grow from a single asset to a diversified global energy and utilities company. This transformation was the product of hard work from dedicated employees at our facilities and head office. That same work ethic will propel Capstone to achieve more in the next decade, overcoming our near-term challenge and fulfilling the company’s potential to become a leader in the expanding global market for essential infrastructure. This investment sector remains in demand for the stability of the returns it offers, the long duration of the assets and the measure of inflation protection it carries.

In a year when Capstone was often tested, the company had the great advantage of dedicated, loyal staff at the facilities and head office, as well as the trusted guidance of a seasoned Board of Directors. I would like to thank and acknowledge everyone for their contribution.

Importantly, I would like to thank our shareholders for investing in Capstone and for their continued support. We appreciate your confidence and are committed to achieving our goals in 2015.

 

Sincerely,

Michael Bernstein
President and Chief Executive Officer